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Worried about the Tax Consequences of Divorce? - Part 2

Worried about the Tax Consequences of Divorce? - Part 2 

BrookWeiner, LLC

This is Part 2 of a two part series.

In Part 1 I talked about the tax consequences of divorce in the following areas:

  • Support provisions
  • Dependency exemptions
  • Property settlements
  • Personal residence
  • Pension benefits

Allow me to forge on with the following areas, which as are equally important in understanding the tax implications and responsibilities during and after a divorce.

Business interests
When certain types of business interests are transferred in connection with divorce or separation, care must be taken to make sure "tax attributes" aren't forfeited. In particular, interests in S corporations may result in "suspended" losses, i.e., losses that are carried into future years instead of being deducted in the year they are incurred. Where these interests change hands in connection with a divorce, the suspended losses may be forfeited. If a partnership interest is transferred a variety of more complex issues may arise involving partners' shares of partnership debt, capital accounts, built-in gains on contributed property, and other complex issues.

Estate planning considerations
The upheaval a divorce causes in family relations and property holdings makes it imperative for the parties to reassess their wills and estate plans in connection with the divorce. First, the typical will in which all property is left to a surviving spouse is no longer likely to reflect the testator's wishes. Mutual family goals, often incorporated in reciprocal wills, are likely to have changed substantially. Second, the property to be left by the spouses may have changed hands via a property settlement. One spouse may be getting substantial holdings he or she didn't previously possess, making it necessary to devise a new estate plan. Finally, guardianship and trustee issues for surviving minor children must be addressed. That is, who will manage the assets of, and serve as guardian for, minor children in the event of the death of the parents.

Medical insurance
If your spouse participates in an employee group health plan that is subject to COBRA, you should know that the plan has the obligation to make COBRA health care continuation coverage available to you, as a qualified beneficiary, if there is a divorce or legal separation. This availability of health coverage extends for 36 months, beginning on the date of the divorce or legal separation. You, however, would have to pay for the coverage (unless, of course, the divorce court orders your spouse to pay for it). This option to buy COBRA health care coverage is available to you even if your spouse discontinued your coverage while the divorce was pending.

Tax records
Make sure you get copies of, or access to, any records or documents that can have an impact on your tax situation. You need copies of joint returns filed with your spouse along with supporting documentation. Also, records relating to the cost of jointly owned property or property transferred to you in connection with the divorce are essential. You will need to establish cost when these assets are eventually sold. And, of course, all documents relating to the divorce or separation itself should be retained for tax (and other legal) purposes.

Filing status
The timing of your divorce or separation can have an impact on how you file your tax return. If a "final" decree or divorce or, in the case of separation, decree of separate maintenance, is issued by the end of the year, then you can't file your tax return for the year as a married person. Your filing status will be "single." However, if you cover more than half the costs of a household in which a child of yours lives, you may qualify for more favorable "head of household" rates.

If an above-described decree hasn't been issued by year-end, you are treated as still married even if you are separated from your spouse under a separation agreement or "nonfinal" decree. In this case, you may still file jointly with your spouse. This filing status may result in lower overall tax for you and your ex-spouse, but may put you at risk for an unpaid tax obligation of your spouse's (although you may be protected under "innocent spouse" rules, and an election to limit your liability may be available in certain circumstances). It also requires contact between the parties to prepare the joint return, which may not be desirable in some circumstances. Further, the alimony deduction discussed above can't be taken on a joint return.

The other available filing status is "married filing separately," which is the least favorable status. However, again, if you cover more than half the costs of a household in which a child of yours lives, and your spouse hasn't been a member of the household during the last six months of the year, you may qualify for a more favorable filing status.

Adjusting income tax withholding
The changes caused by divorce may require you to adjust the amount of income tax that your employer withholds from your paycheck. The calculation of your withholding on the Form W-4, Employee's Holding Allowance Certificate, that you gave to your employer is based on your married status and on the earnings of both spouses. When you get divorced, you should submit a new Form W-4 with the revised information. The fact that deductible alimony payments will be made (or taxable alimony received) should also be taken into account. This will ensure that the correct amount of tax is withheld.

Notifying IRS of a new address or name change
If you will be moving, or if you are changing your name because of divorce, file Form 8822 with IRS so you will receive any notices or correspondence from IRS promptly.

Deducting legal fees
Finally, to what extent can you deduct the legal fees incurred in connection with the divorce? In general, since a divorce is a "personal" undertaking, the legal fees are nondeductible. However, as you can readily see from this discussion, many complex tax issues can be involved in a divorce. And a fee paid for tax advice (including setting up the support arrangement), is deductible as a miscellaneous itemized deduction. (This means it's added to other items in this category, if any, e.g., investment expenses, and is deductible to the extent the total exceeds 2% of adjusted gross income.)

To get a tax deduction for the part of your legal fee that represents tax advice, it's important to have your attorney indicate on his or her bill to you what portion represents tax-related service. If your attorney merely submits a bill "for legal services rendered" you may have difficulty convincing IRS how much, if any, is deductible.

Other legal fees in connection with divorce that may save you taxes include costs to collect alimony payments. Also, if legal work is involved in getting marital assets, the part of fee allocable to the property can be added to its basis. This can save you tax when the property is disposed of.

For all confidential questions on the above information, please feel free to contact us at (312) 629-0900.

Disclaimer: The information in this article is general in nature, and is not intended to be nor should it be treated as tax, legal, investment, accounting, or other professional advice. Before making any decision or taking any action, you should consult a qualified professional advisor who has been provided with all pertinent facts relevant to your particular situation.

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